Banks use of CDS to lower capital targeted by Basel regulators

Global regulators are planning to crack down on banks that underestimate their capital requirements because of the way they use credit-default swaps and other instruments to lower the amount of risk on their books.

The Basel Committee on Banking Supervision said today that it would seek to stop banks from lowering capital charges by buying instruments such as CDS to insure themselves against losses, while failing to recognize the large liabilities they incur from what they pay for this protection, the group said in a statement on its website.

“The proposed changes are intended to ensure that the costs, and not just the benefits of purchased credit protection are appropriately recognized in regulatory capital,” the Basel, Switzerland-based group of international regulators said in a statement. There exists a “potential for capital arbitrage” as banks can book the benefits of these deals without also booking the associated costs, the group said.

The measure is one of many developed by global regulators to bolster banks’ solvency after the financial crisis. For banks, such credit-protection transactions offer a way to redeploy capital more profitably while meeting the stiffer requirements of the latest round of Basel rules.

Critics say the practice doesn’t make the lenders any safer and pushes the lending risk into the unregulated shadow-banking industry.

Blackstone, Citigroup

Blackstone Group LP, the world’s largest private-equity firm, last year insured Citigroup Inc. against any initial losses on a $1.2 billion pool of shipping loans. The regulatory capital trade, Blackstone’s first, let Citigroup cut how much it sets aside to cover defaults by as much as 96 percent, while keeping the loans on its balance sheet, according to two people with knowledge of the transaction.

The Basel committee, which brings together regulators from 27 nations including the U.S., U.K. and China, said it would seek views until June. 21 on amendments to its capital rules that would force banks to recognize the cost of the protection they receive.

The move is in response to “continued activity in high cost credit protection transfers,” the committee said.

“Regulatory capital arbitrage may exist where the immediate capital relief” provided by credit protection “will be offset by the premiums paid” over the life of the contract, the group said.

The Basel group brings together global regulators to co- ordinate rulemaking. Its latest overhaul of banking standards, known as Basel III, was published in 2010 in response to the financial crisis that followed the collapse of Lehman Brothers Holdings Inc.

Under Basel rules, banks are required to set aside a set amount of capital based on the likelihood a borrower will default. Basel III more than triples the core reserves that lenders must hold against possible losses.